THE LURE OF DIAMONDS NAMED FOR JEWELS OR SPIDERS, ETFS FIND NICHE.

Byline: Evan Pondel Staff writer

Looking for an investment that offers a little more pizzazz than the traditional mutual fund?

More investors are trying exchange-traded funds investment tools that have been around for more than a decade but have recently taken off.

Not only do ETFs sound racier than mutual funds with names like Diamonds and Spiders versus New Perspectives and Core Bonds these index tracking funds behave more like a stock.

While structured like a mutual fund, ETFs are bought and sold like stocks, cost less to manage than mutual funds and allow investors to partake in quick swings in the market.

But that's why some financial advisers throw up a yellow flag to potential ETF investors.

For one, ETFs can be just as volatile as common stock and they can also carry heavy commission fees.

And while they've been around since 1993, they have not made significant inroads into the market. As of March 2005, ETF assets totaled $228.72 billion, compared with the $8.0 trillion in mutual funds, according to Investment Company Institute.

"For some investors, ETFs are a better option than a vast majority of traditional mutual funds because they offer trading flexibility," said Dan Culloton, senior mutual fund analyst with MorningStar in Chicago. "They are not the lead pipe-cinch over traditional mutual funds."

Since their creation, investment companies have been looking for creative ways to make ETFs appealing to investors. They've come up with sexy names such as Diamonds, ETFs that track the Dow Jones Industrial Average, and Spiders, which track the S&P 500.

Now their efforts are paying off. In the last year, ETF assets increased $91.5 billion, or 41 percent, the Investment Company Institute reported.

One risk associated with ETFs is that they pose an enticing prospect for day traders because they can be bought and sold in large volumes during a rally.

But also puzzling some investors is whether they should invest in an ETF if they already own a similar index-tracking mutual fund. The answer: It depends on the investor's goals.

J.D. Steinhilber, founder of AgileInvesting.com, said some investors use ETFs as a hedge against other investments, including mutual funds. "They (ETFs) help mitigate the downside of exposure," said Steinhilber, noting that the diversification of an ETF can help keep it afloat when other investments in a portfolio are foundering.

Of the portfolios Steinhilber manages, 75 percent of his clients' investments are ETFs, some of which track energy markets, foreign markets and real estate. There are mutual funds that do the same, but Steinhilber said ETFs are cheaper to buy than other investments.

The difference in cost is explained by the percentage amount (expense ratio) a brokerage firm or fund company charges to manage an ETF versus a mutual fund. For example, Vanguard's Total Stock Market (VIPERs) ETF has an expense ratio of 0.13 percent, while its mutual fund equivalent has a ratio of 0.19 percent.

But Culloton said expense ratios aren't always enough incentive to invest in ETFs. "Smaller investors have to consider that they will have to pay brokerage commissions to buy and sell an ETF. And paying brokerage commissions can add up and erode the low cost advantage of the product," Culloton said. "There are a lot of traditional mutual funds that do just as good a job and you don't have to deal with commissions."

Capital gains tax is another reason why investors should use caution when investing in ETFs. If an investor decides to sell his or her holdings in an ETF, they are on the hook for capital gains tax. "Some people don't realize that as they are trading ETFs they are realizing capital gains," Culloton said.

Of course, keeping up with the myriad ETFs on the marketplace is another challenge for investors. Tom Lydon, owner of ETFTrends.com, said that just like stocks, ETFs can have emotional appeal. A new batch of exchange-traded funds are focusing on companies involved with the fight against cancer.

"A worry of mine ... is investors will act on emotion, and not know what they are doing as far as the financial aspect of it is concerned," said Lydon on his blog. "It might be wise to wait around and see what happens to make sure there are no surprises before investing in these ETFs."

Precious metal ETFs are also drawing attention. With gold recently hitting a 25-year high, two ETFs that invest in gold have caught Lydon's eye: StreetTracks Gold Trust and iShares Comex Gold Trust.

Lydon said he likes ETFs, whether investing in commodities or indexes, because of their purity. "They come in all different shapes and sizes, but you also know exactly what you are buying," he said.

Not from Steinhilber's perspective.

Because ETFs are relatively new, there isn't as much information tracking their progress relative to mutual funds. For that reason, Steinhilber recommends understanding how an ETF is managed and rebalanced. "I tell investors they must get to know the underlying index before getting into an ETF," he said. "Bottom line, dig into the details."

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